Reforming Financial Regulation: A Memo to President-elect Obama

Reforming Financial Regulation: A Memo to President-elect Obama

[W]e need to streamline a framework of overlapping and
competing regulatory agencies. Reshuffling bureaucracies should not
be an end in itself. But the large, complex institutions that
dominate the financial landscape do not fit into categories created
decades ago. Different institutions compete in multiple
markets--our regulatory system should not pretend otherwise. A
streamlined system will provide better oversight, and be less
costly for regulated institutions.

Much of our regulatory apparatus was invented in the
1930s.... [O]ur existing patchwork of federal and state regulation
is not sufficient to provide the rules of the road
in a 21st century economy.[2]

--Obama '08, "Barack Obama's Plan to Restore Confidence in the
Markets, Tackle the Housing Crisis and Help Protect Families from
the Economic Slowdown"

President-elect Obama, during the campaign, you recognized the
need to update America's outdated regulatory framework to meet the
needs of the 21st century. You laid out principles for a revised
regulatory system, specifically criticizing the "balkanized
framework of overlapping and competing regulatory agencies," and
called for a "more streamlined system of oversight." You also noted
that "details of these changes should be developed only after
adequate analysis and public debate."[3]

Adhering to the following guidelines can help you and your
Administration create a financial regulatory system that meets the
needs of the 21st century.

Don't stifle the innovation and financial creativity
that have made U.S. financial markets world leaders. All
too often, regulators see their jobs as making sure that the firms
that they oversee and their products fit in carefully defined
categories. This leads to both stagnation and higher costs for
consumers. While it is tempting after the events of the last year
to consider forcing the entire financial industry into one
regulatory framework complete with strict rules designed to reduce
or eliminate the risk from new products, this would be a huge
mistake. The new financial services regulatory system should make
encouraging innovation a specific priority.

Consumers benefit from innovative products that reduce costs and
expand the number and types of people who can access financial
services. While it is true that many of the "at risk" mortgages
were of new types that did not exist in the past, the problems
exist more from failure to follow proper underwriting standards
than from the products themselves. When proper loan standards are
met, these products have enabled millions of Americans to afford to
own their own homes. The same is true for many credit card products
and investment vehicles.

Finally, the Madoff scandal was caused by activities that were
criminal decades before the first hedge fund. It is a serious error
to equate the financial vehicle with illegal activities.

Replace rules-based regulation with regulation based on
standards. There is no such thing as a perfect financial
regulatory system that will eliminate all risk to companies,
consumers, and countries. Moreover, an attempt to create one
through a series of overly specific regulations would only end up
damaging the national economy and temporarily stifling the
industry.

This approach should be avoided at all costs. Today's financial
regulatory system is based on specific rules that define whether an
activity is legal or not. While most of those rules do an adequate
job of protecting the stability of the financial system and the
interests of the public, many do not. In a dynamic market, it is
very easy for financial, legal, and accounting experts to devise
ways to circumvent specific rules. By the time rules have been
adjusted, it is too late.

All too often, Congress reacts to a situation by writing even
stricter rules that only serve to damage the industry, raise costs
for consumers, and drive good jobs overseas. Rather than attempting
such an approach, the new financial regulatory system should be
based on standards that financial firms would have to meet. Firms
would have choices about how to meet their responsibilities, and
the standards would be flexible enough to allow regulators to step
in quickly when it
is necessary.

Banning specific products or attempting to force all types of
financial firms to meet one set of standards will only drive more
financial jobs to other locations. If there is a demand for
specific products and services, that demand can be met just as
easily by companies located outside of the U.S. as by those in New
York or Chicago. Instead of banning products or trying to
straitjacket the industry, your new financial regulatory system
should focus on how to ensure that products and services are
provided at acceptable risk levels with appropriate disclosures to
both individual investors and entities that monitor systemic
risk.

Reduce the number of regulatory agencies and
rationalize their jurisdiction. As you have noted, today's
fragmented financial regulatory system is a product of the 1930s.
It reflects a financial industry that no longer exists. There is no
longer any reason to have four separate agencies regulating banks
or three agencies regulating securities exchanges. Today's system
lacks clear lines of responsibility. The past several decades have
seen a remarkable consolidation of entities providing financial
services, and the recent market crisis has accelerated that
trend.

Government regulatory categories and jurisdictions need to
correspond to these changes in the real financial economy. Most of
the entities and distinctions born of the economic crisis of the
1930s no longer have relevance today. Crafting an appropriate
response to the first major economic crisis of the 21st century
with 70-year-old definitions and tools will be impossible.

Instead, you should consider replacing the current system with a
streamlined agency or agencies with clear lines of jurisdiction. It
would be appropriate to allow one agency to oversee the systemic
risk to the financial services industry while another oversees the
business side of the industry and a third deals with consumer
issues. Other organizational structures could be equally
appropriate. However, past efforts to reform financial regulators
have broken down as a result of institutional jealousies between
regulatory agencies and specific types of financial entities.
Rather than tinkering, it would be far better to sweep the old
structures away and replace them with new entities.

Similarly, divided congressional committee jurisdiction presents a
barrier to comprehensive reform of regulatory roles and
jurisdictions. The Agriculture Committees, for instance, have
already begun insisting on maintaining or expanding their
jurisdiction over the Commodity Futures Trading Commission, despite
real-world changes that have moved futures markets far from their
agricultural roots and increasingly into financial products.[4] A
comprehensive reform should also place the congressional
jurisdiction over financial services under one committee.

Define and implement a clear TARP exit
strategy. You should charge officials in charge of the
Troubled Assets Relief Program (TARP) to begin immediately to plan
for the orderly withdrawal of government support from those
institutions that no longer need it and for the orderly sale or
disposition of assets acquired. They should also plan for the
closure of the various credit facilities instituted by the Federal
Reserve at the earliest possible time. Such steps may include
creation of a Resolution Trust Corporation-type agency like the one
used to liquidate the assets of savings and loans in the early
1990s to manage and sell mortgage-related and other assets acquired
through the TARP program and the various Fed programs.

Ensure that American national interests are
protected. The recent financial turmoil has led a number
of international leaders to propose the creation of an
international regulatory system that would impose common rules on
all financial institutions. While there is a good case for
coordinating national regulatory systems, it would be a huge
mistake for the U.S. essentially to cede control of our industry to
others.

The statements of leaders from the European Union and various
other nations make it clear that they see an international
regulator as a way to control American financial institutions. This
was illustrated most dramatically by an EU proposal to require that
all securities sold in the EU be rated by a credit rating agency
physically located in the EU, even if the financial instruments are
actually issued in another area.

An international system of independent national regulators that
use common terminology and have similar standards is appropriate.
However, American national interests should never take second place
to an international regulator.

Conclusion

Financial experts have warned for several decades that the
current U.S. financial regulatory system is fragmented and
inadequate. Rather than prevent problems, the current system has
exacerbated them in many ways. The events of the past several
months show that reforming that system cannot be put off any
longer. However, it would only make matters worse to replace it
with draconian attempts to micromanage the financial services
industry. That approach would both harm consumers and send
high-paying jobs overseas.

The new financial regulatory system must have clear lines of
responsibility and allow the industry to continue to innovate. It
must be flexible enough to adapt to new realities in the global
marketplace quickly while still ensuring that our national
interests are protected.

The financial services industry has played an essential role in
creating prosperity. An appropriate regulatory system will allow it
to continue to play that role in the future.

David C. John is
Senior Research Fellow in Retirement Security and Financial
Institutions, and David M. Mason is Senior Visiting Fellow, in the
Thomas A. Roe Institute for Economic Policy Studies at The Heritage
Foundation.